TWN Info Service on Finance and Development (Feb09/02)
17 February 2009
Third World Network

Asia hit again - what lessons now?
Published in SUNS #6639 dated 13 February 2009

Geneva, 12 Feb (Yilmaz Akyuz*) -- It has been more than a decade since a virulent financial crisis devastated several Asian economies with excellent track records in economic development and macroeconomic stability.

The crisis increased the awareness that vulnerability to financial contagion and shocks depended in large part on how capital inflows are managed, and that governments may have limited options in addressing the sudden stops and reversals that often mark short-term capital flows.

After a brief interruption, capital flows to Asia, as well as other emerging markets, recovered strongly in the earlier years of this decade, growing constantly and surpassing previous peaks. These flows were greatly influenced by the very same factors that led to a surge in speculative lending in the United States and elsewhere in the developed world - notably, ample global liquidity resulting from a policy of easy money and search for yield.

Rather than tightening restrictions over capital inflows, most countries in Asia have chosen to relax restrictions over non-resident inflows and resident outflows. However, drawing on the lessons from the 1997 crisis, they have also strengthened their external payments and absorbed excess supply of foreign exchange by accumulating large amounts of reserves as a self-insurance against sudden stop and reversal of capital flows.

As a result of these policies, the Asian emerging markets are now much more closely integrated into the international financial system than they were in the run-up to the 1997 crisis. Foreign presence in Asian financial markets has increased not only because of historically high non-resident portfolio inflows, but also because of increased penetration of foreign-owned banks and other financial firms. Net resident outflows have reached unprecedented levels, particularly through portfolio investment rather than direct investment.

This process has resulted in greater fragility of the domestic financial system by contributing to credit, asset and investment bubbles even though payments and reserve positions of many of these countries are strong enough to provide insurance against balance-of-payments and exchange-rate crises of the kind experienced during 1997.

Several countries, notably China, India and Korea, experienced bubbles in equity and property markets after the early years of this decade, with price increases going well beyond levels justified by fundamentals. These have also been accompanied by unprecedented and unsustainable increases in investment in China and India, not only in construction and property, but also in industry.

The surge in capital flows made an important contribution both directly and also by giving rise to a rapid liquidity expansion, since central bank interventions in foreign currency markets aiming at preventing currency appreciations could be only partially sterilized.

The closer global financial integration has also inflicted significant costs on Asian emerging markets and made them more susceptible to shocks and contagion from the current global financial turmoil triggered by the sub-prime crisis.

Of the $2.4 trillion reserves accumulated in Asia after 2001, 40 per cent came from capital inflows: that is, they are "borrowed" in the sense that they accompany increased claims by non-residents in one form or another, which entail outward income transfers.

These borrowed reserves are approximately equal to the total external debt of the region. They typically yield a lower return than the borrowing costs. Assuming a moderate 500-basis-point margin between the interest cost on debt and the return on reserves, this would now give an annual carry cost of some $60 billion for the region as a whole.

The increase in the share of foreign assets in national portfolios has also resulted in greater exposure to instability in market valuation of these assets in mature markets as well as exchange rate swings.

Asian economies do not have large direct exposure to securitised assets linked to sub-prime lending, even though some significant losses have been reported in the region. However, they appear to have invested large amounts in debt issued by the United States Government Sponsored Enterprises, including mortgage firms Fannie Mae and Freddie Mac.

Holding by central banks outside the United States of such debt is estimated to be in the order of $1 trillion and large amounts are also known to be held in private portfolios. China's holding of United States agency debt is estimated to be at least 10 per cent of its GDP, mostly in Fannie and Freddie assets.

Had the United States government not bailed out these institutions, losses would have been severe. Moreover, should the dollar come under pressure, countries with a large stock of dollar reserves stand to incur considerable exchange rate losses.

Asian emerging markets are hurt by sharp swings in capital flows a lot more than expected. These flows, including bank-related capital, initially kept up after the outbreak of the sub-prime crisis, but with the deepening of the credit crunch, there was first a moderation followed by a sharp decline.

According to the latest estimates by the Institute of International Finance, capital flows to emerging markets as a whole fell to $444 billion in 2008 after reaching some $950 billion in 2007. Net portfolio flows in 2008 was negative by $89 billion and it appears that all of the money that came into emerging markets funds in 2007 came out again in 2008.

The decline in capital flows to Asia is even more marked, from $315 billion in 2007 to a mere $96 billion in 2008. Direct investment remained relatively resilient, but with the deepening of the credit crunch in the United States and Europe, there was a sharp drop in commercial bank credits, from $156 billion to an estimated $30 billion, and this is expected to turn negative in 2009.

Net portfolio equity flows to Asia, including outflows by residents, were already negative in 2007, and they are expected to have become even bigger in 2008, reaching $55 billion. Redemption by highly-leveraged hedge funds from the United States and United Kingdom appears to be an important reason.

These institutions had been very active in Asian equity markets in the earlier years. They are now hard hit by the sub-prime crisis, and de-leveraging by them appears to be a main reason for the exit of equity portfolio investment from emerging markets as a whole. Thus, emerging markets are providing liquidity to portfolios managed in the major markets in order to cover their mounting losses and margin calls.

With rapid exit of foreign capital and global retrenchment of risk appetite, asset bubbles in Asia have come to an end. Equity markets lost around half of their values since the beginning of 2008 in China and India. Booms in property markets too are now bust.

In China, house prices declined in December 2008 for the first time since the government started releasing the data in 2005, and urban fixed asset investment has been falling since September 2008. The government is now taking measures to revive the property market.

In Korea, the slump that started in 2008 is now threatening to set off a process of debt deflation, reminiscent of the 1997 crisis when housing prices fell by some 13 per cent.

This cycle in Asian asset markets has many features reminiscent of those in the 1990s, but is different in an important respect. In the current cycle, asset deflation is not associated with currency crises and interest rate hikes, but severe trade shocks. The combination of asset deflation with sharp drops in exports and consequent retrenchment in investment can no doubt wreak havoc in the real economy.

This explains why in Asia now the slump in industrial production appears to be more significant and more rapid than in 1997-98. It is estimated that some Asian countries, notably Korea and Singapore, experienced severe (double-digit) contraction in output during the last quarter of 2008. In China, where manufacturing output also dropped, loss of employment reached some 20 million.

To contain the impact of the crisis, it is important to avoid destabilizing feedbacks between the real and financial sectors, particularly in China because of its wider regional ramifications.

In China, the bulk of recorded profits are earned by relatively few enterprises while the rest have high leverage so that if growth slows significantly, a substantial proportion of bank loans can become non-performing. This could threaten the solvency of the banking system which can, in turn, lower growth further.

Whether or not the massive fiscal package proposed by the government would prevent such an outcome remains to be seen. In any event, the challenge faced by China is not only to overcome the deflationary impulses from the sub-prime crisis, but to shift to a growth trajectory led by the expansion of domestic consumption. This calls for more rapid growth in wages and higher share of wages in GDP.

Even though the region as a whole has strong payments and reserve positions, the behaviour of capital flows, including resident outflows, is likely to continue to exert a strong influence on the space available for policy response to external shocks from the sub-prime crisis and hence the performance of several economies of the region.

Because of the sharp slowdown in total capital flows and reversal of portfolio flows, several currencies that had faced constant upward pressure against the dollar (and the yuan) after 2003, particularly the Indian rupee, Korean won and Thai baht, have been falling sharply against both currencies since summer 2008.

Given strong deflationary impulses from the crisis, this may be viewed as a welcome development, and unlike 1997, governments now seem to be wary of throwing all their reserves into stabilizing their currencies.

However, in some of these countries, notably India and Korea, reserves have been declining rapidly as a result of exit of capital and growing current account deficits. In many respects, Korea appears to be in worse shape since 1997, experiencing sharp drops in its currency vis-a-vis the dollar and creating fears of an impending financial crisis.

Thus, the lessons learned from the 1997 crisis and strong payments and reserve positions do not appear to be protecting the countries in the region against shocks and contagion from the sub-prime crisis. This experience shows once again that when policies falter in managing financial integration and capital flows, there is no limit to the damage that international finance can inflict on an economy.

(* Yilmaz Akyuz is Former Director, Division on Globalization and Development Strategies, UNCTAD, Geneva. This article draws on a paper, The Management of Capital Flows and Financial Vulnerability in Asia, forthcoming in Third World Network's Global Economy Series No. 16.) +